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Valuing Gold Mining Stocks

Does discounted cash flow (DCF) apply to Gold Mining ventures...?

While the BANKING SECTOR rallies, and as stock markets take heart from Apple's blow out earnings results – because better technology will lead us out of a debt crisis – we'd thought it better to write today about value, says Dan Denning in his Daily Reckoning Australia.

That is, how do you accurately value the future earnings of a company that doesn't have any cash flow?

Remember that the financial industry largely has one goal: to sell you whatever you're willing to buy and make a commission on it. With gold making news, you can expect a lot of new Gold Mining companies, or old companies claiming they've found new gold (or in the case of old mines, old gold!) to step up shortly.

A lot of the press releases that come from new Gold Mining companies sound great, especially when bullish comments from "analysts" and the underwriting investment bank are included (if it's a new float). This reminds your editor of a conversation we had about five years ago with a resource guru back in the States.

"You have a real advantage in the early days of a bull market because everyone in the financial industry has forgotten how to value gold companies. This is what happens in a bear market. Prices stay flat and companies try to and orient themselves to other commodities. You had a twenty year bear market in gold. The whole generation of financial analysts and planners went through school learning discounted cash flow models as the only valuation tool. But that doesn't work with junior miners. These guys will have no idea what to pay for a gold stock, or why you should even buy one."

"Why doesn't the DCF model work for juniors?" we innocently asked.

He chuckled...

"You know what a gold mine is don't you? It's a hole in the ground with a liar standing next to it, usually. But not always."

"But if you're buying them because they can go up like a growth stock, whey wouldn't you value them the same way?" we asked.

"Because exploration companies don't usually have earnings. The usually just have a whole lot of expenses and a poorly defined resource that MAY be leveraged to higher metals prices. The only certainties they have are costs...and even those aren't certain. Capex and opex costs almost always rise during a boom as the demand for mining services and miners goes up. No serious gold stock analyst would slap a valuation on a junior based on a DCF model with so many unknown variables. It's not credible."

We recalled the conversation because on page eight of today's Financial Review there's an article about how ASIC has warned "independent experts" not to use DCF models when projecting earnings for junior miners. In simple terms, a DCF model is rubbish when there are no cash flows. What is the present value of future earnings when there are no earnings present?!

So how DO you value companies that have projects and perhaps a poorly defined resource (or maybe proven reserves) but no current production? The old industry stand-by is to use a ratio between the market capitalization of the company and either the proven reserves or a general resource figure. This begins to give you an idea of what you're paying, per share, for each ounce of gold in the ground (or gold that could be 'proved up' into something economically producible).

For the major gold producers with defined reserves, a clear capital structure , and a portfolio of assets, this is one way (the market cap/oz of proven reserves ratio) of weighing up which company gives you the most gold for your investment/speculative Dollar. But it is a bit more complicated than that. There is even an argument that in markets where underlying commodity prices are rising (for whatever reason) the best stocks to own are the companies with the largest resource, but that are not actually producing anything yet. As our friend Joanne Nova at said a few years back, gold in the ground is like, "an 'option' to own gold cheaply, with no expiration date."

But whether you prefer your gold in the ground, in a Bullion Vault, or in your pocket is really up to you. Of course it could be that you think the whole idea is rubbish anyway, or that gold has already run its race. In the meantime, nothing really happened in the markets overnight to convince us that the underlying situation isn't awful. Bank shares rallied. But the ownership and thus the value of the principal assets in the American banking system are in dispute. That's not just bad for US banks. It's bad for all banks. Nobody is immune from the fall out.

Over in France, the austerity (raising the retirement age from 60 to 62) has hardly begun and the French (mostly the young, naive, and grossly spoiled students) are protesting and bringing transport to a halt with a general strike. Actually it's the interruption of fuel supplies that's causing the trouble.

But at the heart of the dispute is again a misunderstanding about value. The French students – like so many people in the Western world who were born, brainwashed, and bamboozled by the ethos of the times – think you can get something for nothing, or that we can all live at one another's expense without anyone really doing any work. It is the "great lie" of our time. People have heard it so much they actually believe it and demand it as a right!

Something cannot come from nothing. Profit – the stuff that pays taxes to finance the Welfare state – is surplus value; when labor or design or technology makes the whole worth more than the sum of the parts. The French (like post World War two Americans) have been living off of accumulated capital for years. The US, having less time to accumulate capital and having seen much of it off-shored in the last 30-years, has made up the difference with debt.

That's more or less where we are on a Tuesday, in the grand sweep of Western history. We are also close to lunch time. And the place across the street has an excellent chicken sandwich, served with bacon and avocado on multigrain bread. It costs about ten Dollars in the incredibly strong Aussie Dollar. And, unlike, gold, you can eat it!

Just because you can't eat gold, though, doesn't mean it isn't the best store of value going. It has been for many years. And now, when governments all over the world are in a race to steal growth from one another through currency debasement, we're buying on dips and on strength. The great subprime/debt reckoning is coming.

Get gold, get it inside a vault, and get it off-risk for anyone else's financial performance – go to BullionVault and start with your free gram in Zurich right now...

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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